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Saturday, January 28, 2012

This year we'll see more painful evidence of Australian businesses accepting the new reality: our dollar is likely to stay uncomfortably high for years, even decades.

It has suited a lot of people to believe that just as the resources boom would be a relatively brief affair, so the high dollar it has brought about wouldn't last.

If there were no more to the resources boom than the skyrocketing of world prices for coal and iron ore, that might have been a reasonable expectation. But the extraordinary boom in the construction of new mining facilities makes it a very different story.

The construction boom is likely to run until at least the end of this decade, maybe a lot longer. The pipeline of projects isn't likely to be greatly reduced by any major setback in the world economy. That's particularly because so much of the pipeline is accounted for by the expansion of our capacity to export natural gas. The world's demand for gas is unlikely to diminish.

Last time I looked, the dollar was worth US105?, compared with its post-float average of about US75?. But that's not the full extent of its strength. At about 81 euro cents and 67 British pence it's the highest it's been against those currencies for at least the past 20 years.

In the context of the resources boom, the high exchange rate performs three economic functions. First, it helps to make the boom less inflationary, both directly by reducing the prices of imported goods and services and indirectly by lowering the international price competitiveness of our export- and import-competing industries.

Second, by lowering the prices of imports, it spreads some of the benefit from the miners' higher export prices throughout the economy. In effect, it transfers income from the miners to all those consumers and businesses that buy imports, which is all of them. So don't say you haven't had your cut.

Third, by reducing the price competitiveness of our export- and import-competing industries, it creates pressure for resources - capital and labour - to shift from manufacturing and service export industries to the expanding mining sector.

That is, it helps change the industry structure of the economy in response to Australia's changed "comparative advantage" - the things we do best among ourselves compared with the things other countries do best.

As businesses recognise the rise in the dollar is more structural than temporary and start adjusting to it, painful changes occur, including laying off workers. Paradoxically, this adjustment is likely to raise flagging productivity performance.

Economists have long understood that the exchange rate tends to move up or down according to movement in the terms of trade (the prices we receive for exports relative to the prices we pay for imports). This explains why the $A has been so strong, for most of the time, since the boom began in 2003.

But here's an interesting thing. In the December quarter of last year, our terms of trade deteriorated by about 5 per cent as the problems in Europe caused iron ore and other commodity prices to fall. They probably fell further this month.

This being so, you might have expected the $A to fall back a bit, but it's stayed strong and even strengthened a little. Why? Because when the terms of trade weakened, other factors strengthened. The main factor that's changed is the rest of the world's desire to acquire Australian dollars and use them to buy Australian government bonds.

Indeed, the desire to hold Australian bonds was so strong it more than fully financed the deficit on the current account of the balance of payments in the September quarter. It may have done the same in the December quarter. Among the foreigners more desirous of holding our bonds are various central banks.

Remember that, at the most basic level, what causes the value of the $A to rise on any day is that people want to buy more of them than other people want to sell. The price rises until supply increases and demand falls sufficiently to make the two forces equal.

So economists' theories about what drives the value of the $A are just after-the-fact attempts to explain why the currency moved the way it did. We know from long observation that there's a close correlation between our terms of trade and the $A.

But we also know this correlation is far from perfect. There have been times when the two parted company for a while. It's apparent the dollar is driven by different factors at different times.

And it now seems apparent that our relatively superior economic performance and prospects are taking over as the main factor driving the dollar higher (even though our terms of trade would have to deteriorate a mighty lot further before they were back to their long-term average).

There are various reasons why foreign investors (including central banks with currency reserves that have to be parked somewhere) would like to increase their holdings of Australian government bonds.

For a start, we're now one of the few "sovereigns" (national governments) still with a AAA credit rating. For another, the yield (effective interest rate) on Australian 10-year government bonds is almost 4 per cent, compared with about 2 per cent on US Treasury bonds or German bunds.

And the present and prospective state of our economy is a lot healthier than that of the North Atlantic and Japanese economies. Why are our prospects so much brighter and our interest rates higher? In short: the mining construction boom, of course.

It seems clear the world's financial investors are shifting their portfolios in favour of $A-denominated financial assets. And remember, because they're so much bigger than we are, what's only a small shift for them is a big deal for us.

All this suggests the Aussie will stay strong, even as our terms of trade fall back. Remember, too, the huge spending on mining construction over the years will require a lot of foreign financial capital to flow into Australia, helping keep upward pressure on the exchange rate.

This doesn't say the $A has become a safe-haven currency. Were some sudden disaster to occur in Europe it would probably take a dive as frightened investors rushed to the safe haven of US Treasury bonds.

But it probably wouldn't take long for the Aussie to recover - just as it didn't take long after the sudden disaster of the collapse of Lehman Brothers in 2008.